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Integrated Markets Part I

Integrated Markets Part I. Covered Interest Parity. Conditions for Integration. Four increasingly demanding conditions Covered interest parity Uncovered interest parity Real interest parity Feldstein/Horioka. Covered Interest Parity. i $ = interest rate in USA

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Integrated Markets Part I

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  1. Integrated MarketsPart I Covered Interest Parity

  2. Conditions for Integration • Four increasingly demanding conditions • Covered interest parity • Uncovered interest parity • Real interest parity • Feldstein/Horioka

  3. Covered Interest Parity • i$ = interest rate in USA • i¥ = interest rate in JPN (Both yearly) • F = forward exchange rate ($/¥) • E = spot exchange rate ($/¥)

  4. Covered Interest Parity • One dollar in USA will earn $1*(1 + i$) by next year • This money invested in Japan will earn $1*(1 + i¥)/E in yen by next year • Two different currencies • ER, one year from now, is unknown

  5. Covered Interest Parity • What can we now do? • SELL (1 + i¥)/E yen in the FORWARD market for F*(1 + i¥)/E dollars • Restated, this dollar amount is: • (1 + i¥)F/E, and is equal to the dollar earnings if invested in USA

  6. Covered Interest Parity • OK, now: • (1 + i$) = (1 + i¥)F/E, or • (1 + i$)/(1 + i¥) = F/E

  7. Covered Interest Parity • Now, subtract 1 from both sides: • (1+i$)/(1+i¥) - (1+i¥)/(1+i¥) = F/E – E/E, • (i$ - i¥)/(1 + i¥) = (F – E)/E

  8. Covered Interest Parity • Because 1 + i¥ is about equal to 1, (i$ - i¥) = (F – E)/E

  9. Out of a recent WSJ: E = .009482; F (6 month) = .009537 F – E = .000055; so, 55/9482 = .0058 for 6 months or .0116 for a year In % terms, that is 1.16% differential

  10. 1.16% of What? • (i$ - i¥) = 1.16% • Later we’ll see this is an underestimate, or my other estimates are over estimates

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